The core of the Federal Reserve Act

The core of the Federal Reserve Act is the stipulation that member banks must maintain with the Federal Reserve banks statutory minimum reserves against their deposits. These required fractional reserves are the means by which the member banks are tied to the 12 Federal Reserve banks. The establishment of the Federal Reserve System in 1914 changed the concept of the principal function of legal reserves from that of providing liquidity to individual banks, i.e., the ability to meet withdrawals, to that of serving as an instrument for controlling the total volume of bank credit, the money supply, and interest rates.

The traditional view that the primary purpose of legal reserves is to assure adequate bank liquidity is obviously erroneous, since a bank can meet only a part of a withdrawal with legal reserves. A bank may draw on its required reserve and be temporarily deficient provided on other days it has excess reserves sufficient to bring the average amount held during the computation period (weekly for central reserve and reserve city banks and semimonthly for country banks) to the required ratio.

Hence, it may be stated that the liquidity of an individual bank rests primarily on its secondary reserve assets such as Treasury bills, other Government obligations maturing within one year, bankers' acceptances, commercial paper, and brokers' loans. These short-term credit instruments can be converted immediately or on short notice into cash without significant loss. The liquidity of the banking system as a whole, however, is based ultimately on the credit-expansion power of the Federal Reserve banks.

The required reserves are funds that the banks cannot lend or invest to earn an income. They represent a contribution by the member banks to enable the Reserve authorities to limit the volume of bank credit, and at the same time constitute a pool of reserve funds from which the banks can borrow in case of need. Since loans and investments create deposits against which the member banks must maintain stipulated reserves, the volume of reserves and the legal reserve requirements set a limit to the total loans and investments of the banking system. It is obvious that the lower the percentage of reserve requirements the greater the volume of credit and deposit expansion a given amount of reserves will support, and the greater will be the credit contraction necessitated by a reduction in the amount of reserves.

Nonmember banks tie up a smaller percentage of their deposits in reserves than member banks, owing to the generally lower reserve requirements imposed by many states and the permission to count vault cash as a part of reserves. Some states even permit investment of a percentage of the reserves in interest-bearing public securities. Moreover, nonmember banks are permitted to deposit their reserves with correspondent city banks, thus making the legal reserve serve simultaneously as the customary correspondent balance. On the other hand, a member bank must keep its legal reserve with the Federal Reserve bank and at the same time hold cash and maintain balances with its correspondents as needed. In contrast to the immobilized reserves of the member banks, reserves in the form of correspondent balances are not idle funds for the banking system since the depositary banks lend and invest these balances (interbank deposits), except for the fraction of the deposit which the depositary member bank must keep as a required reserve with the Reserve bank. This weakens somewhat the power of the Reserve banks to control effectively the volume of credit.